Description

APL Apollo Tubes (APL) is an interesting play on investing in India's building products sector. APL is the largest player in the structural tubes segment, and while structural tubes might seem like a commodity, the company has built moats around it to dominate the market. The company has about 40% market share, which is only expected to increase going forward with weak competition and an aggressive management that has demonstrated a strong track record of expanding the business, introducing new products to expand the market, and building the lowest production cost facilities across the country.  I believe APL is an attractive long-term investment opportunity to participate in a structural industry, where we can expect 15-20% earnings cagr and multiple rerating. 

Company info and history:

APL is India’s largest manufacturer of structural tubes, with ~40% market share in a fragmented industry. It has a capacity of 2.5mtpa with a pan-India presence; 10 manufacturing units, 29 warehouses, 800 distributors, and a strong dealer network with over 40k retail touchpoints. The real journey for APL started after Sanjay Gupta took over the business in 2002. Since then the company has added capacity at 20%+ cagr (including inorganic expansion) and its revenue has grown at over 35%+ cagr. Company has done 5 acquisitions since 2008, and post the acquisition of these plants, the company has then increased the plant capacity significantly (0.6mtpa capacity at the time of acquisition which has expanded to 1.3mpta through brownfield expansion). APL has also been at the forefront of launching most of India’s first niche products within the structural steel segment and has helped expand the end-use applications of the product.

Industry:

Structural tubes are a subset of Electric Resistance Welded (ERW) pipes. Until about a decade and a half ago they were mostly used to transport water, sewage, and oil/gas, but of late they have found new applications as structural support systems for modern infrastructures. Currently, the structural steel industry is estimated to be around 4mtpa and has grown at ~8% cagr (over 1x GDP in the last 5 years). The current structural steel adoption is very low in India (about 4% of total steel consumed vs about 9% for developed countries). Going forward, with increasing use cases and higher usage of steel in residential and commercial buildings, the demand for structural steel is expected to grow ~10% cagr from 4mt in fy20 to 5.4mt in fy25. Structural steel tubes are mostly used in residential and commercial building applications (40% and 30%, respectively); infrastructure accounts for about 25% of total consumption.   

Investment thesis:

Gaining market share in a growing industry segment: Structural steel tube industry is gaining acceptability for increasing residential and commercial building applications along with infrastructure applications. Currently, the street is expecting the structural tube industry to grow at ~10% CAGR. Within the industry, APL is gaining market share. Company’s market share has improved from 29% in FY16 to about 40% in FY20. I believe the market share should continue to increase due to its pan-India presence, excess capacity (current capacity utilization is around 65%), ability to provide customized and low volume products to customers, and continuous product innovations. Just in the last few years, the company has launched quite a few niche value-added products like Signature (designer roofing, fencing, and steel furniture), Chaukhat (steel door frames to replace traditional wooden door frames), Alpha (window steel frames), Elegant (designer steel hand railings), Tricoat (electrical conduits), Plank (staircase steps, ceilings, etc).

Good experienced management team with risk-taking ability: After Sanjay Gupta took the reins of the company in 2002, he has managed to aggressively grow the company by not just increasing capacity but also by being the early adopter of new technologies, introducing new products to the market, building brand around a normally commoditized product, and doing backward integration to reduce the cost of the entire value chain. Management is highly passionate about the business and wants to be by far the single largest player in the market. Management understands that economies of scale play an important role in a low margin business and that the huge cost advantage they will gain will deter newer players from entering the business.

Margins improvement possibility: Company is working on many angles to improve margins including i) increasing the portion of high margin value-added products, ii) focus on reducing cost, and iii) Improving branding to sell products at a premium.  

•  Currently, the revenue contribution from high-margin products (DFT-hollow sections, GI pipes, GP pipes, and Tricot products) is about 35% (from 30% in FY17) and this should increase to ~50% over the next 4-5 years. The EBITDA/ton for high margin products is about 3x more than low margin products. EBITDA/ton for the low margin commoditized products like MS-Black and Hollow section is about Rs 1350, while for the high-value products it can range from Rs 2,500-6,000, and so the shift towards high-value products will significantly improve their operating profits on a per ton basis.

• Secondly, the management clearly understands that in low margin products, only the lowest cost producers can survive in the long-run and so APL is highly focused on reducing its production cost per ton. APL is able to get the lowest raw material (HRC steel) prices and best working capital terms among its peers because it is by far the largest customer among its peers. APL has 40% market share, while #2 and #3 players have about ~12% and 10% market share. APL buys about 2% of India’s steel consumption and about 10% of India’s HRC steel, which gives it much higher bargaining power. Additionally, the company has recently adopted Direct forming technology (DFT), which allows the company to mill pipes of any size and shape (round, square, and rectangle) and the process is highly automated compared to conventional technology, which is used by peers. This saves the company about 2-10% on raw material when compared with conventional technology. With conventional technology, one needs to first mill the pipes into round shapes and then give them a square or rectangular shape. Also, the size of the pipes milled using the conventional technology was limited and any change in the milling size would require the entire set up to be manually reconfigured, which can take up to 2days. With the DFT technology, this process is automated and there is very little downtime. But the cost of this technology is about 10x that of conventional technology, and so the smaller players are not able to afford it.

• In India, many commodity products such as paints, plastic pipes, consumer staples, etc, the branded players have a huge pricing advantage over the unbranded players. Branding of such commodity products is required to distinguish the quality of products and the applications of new products launched. The company’s management understands this, and so has been focusing on building its brand over the last few years. Company has been spending about Rs 500m per year (~6% of gross profits) for the last 2 years on advertisements to promote its brand and new product launches.  

Increasing the company’s moat has been a key focus for the management. In a low margin business, management understands the importance of economies of scale and hence has built massive capacity across the country with a wide distribution network. Company has done backward integration and deployed the best manufacturing technology to make sure it has the lowest cost of production. Additionally, the management has taken the initiative to launch new products in the market to expand the industry size and provide the best quality products. When we did some channel checks with small residential and commercial builders in a few Tier-2 cities, we were surprised to find out that the small-time contractors were brand conscious and preferred to use APL pipes over local brands despite having to pay a small premium. Few other things that the builders appreciated were the high range of size and shapes that they could find with APL. On the other hand, when we checked with some retailers and distributors, they preferred to sell APL products given they didn’t need to store high inventory (APL warehouses in the vicinity were able to replenish products within 1-2 days).  

Potential improvements in ROIC/ROEs:  While improving margins will help improve returns, the company has a lot of room to improve its asset turn. Currently, the company’s capacity utilization is about 65% and with no new capacity expected for the next 1-2years, the improving utilization will help increase the asset turn. But most importantly, the company is focused on improving its working capital cycle. Company expects to reduce its receivable days from 23 in FY20 to about 10days in FY21 by focusing on cash sales. On the inventory side, the company wants to reduce its inventory from 38days to about 30days. So a 20days reduction in their working capital cycle can improve their returns from 18% to 27% in about 2 years.

Valuation is attractive: APL is currently trading at about 33x this year’s earnings and about 23x next year’s street estimates.  While on the surface, the valuation might look expensive, the valuation is actually attractive for these reasons: i) Industry penetration is low; the applications for structural tubes is increasing; the industry is expected to grow at least 10% cagr; within the industry, APL is expected to increase its market share, ii) operating profits and earnings are expected to grow faster than topline due to ability to increase margins as discussed previously, iii) company is the dominant industry player and has a strong moat, which is only increasing, iv) In India, companies like Asian Paints, Berger Paints, Astral Poly Technik are trading over 50x earnings, because these companies have converted commodity categories like paints and plastic pipes into pseudo consumer brands, because of they have strong brand recall and carry pricing power.  

Competitive advantages over peers:

Raw material cost advantage: company is able to source HRC steel at the lowest price compared to peers due to its scale, and this gives the company about 1-2% cost advantage. Additionally, after the adoption of DFT, its wastage portion has dropped giving it another 2%+ saving on the raw material.   

Pan India presence and strong distribution network affords cost-benefit: Steel tubes/pipes are very bulky to transport and so having regional manufacturing plants provides a strong advantage. Additionally having a wide network of warehouses allows it to reduce the inventory level at distributors and retailers, which reduces the working capital cycle of the supply-chain – this they can exchange for better pricing/lower distribution margins.  

Strong product portfolio: APL has over 1.5k SKUs, which it is able to produce due to its advanced production facilities. For about 40% of its portfolio, they have no competition – these are typically low volume but high margin products.   

Strong balance sheet and aggressive management: Company’s balance sheet is strong with about Rs 3bn of net debt or less than 1x EBIT, despite expanding capacity aggressively and doing 5 acquisitions in the last 12years. Management is not shy of investing in technology and doing strategic acquisitions to increase its competitive edge. 

Competition is weak: There are a few small players in the organized space. Surya Roshni is the #2 player with about 10% market share but they have a lot of other businesses and within the pipe segment the company is focused mostly on water transportation. Hi-tech pipes and Rama Steel have about 7% market share each but both are saddled with high debt levels.  APL has about 800 distributors while Hi-tec has about 350 and Surya Roshni has about 250. When we look at the receivable days, APL’s RC days are about 28, while for Hitec and Surya Roshni it is about 37 and 51days, respectively. 

Risks: 

Steel price volatility: Company is affected by steel price fluctuations. While the company is able to pass on the increase in steel prices to customers (typically with a few month lag), the fluctuations can impact their inventory gains/losses, working capital, and if steel prices increase significantly then customers might look for alternatives products. 

New entrants: While existing players are weak, new upstream players with a strong balance sheet might consider entering this business. 

APL Tricoat: Company currently owns about 55% stake in this subsidiary. APL Tricoat (separately listed) is positioned towards the value-added products and has a much higher margin compared to APL. APL’s management has stated its intentions to increase its stake in Tricoat, but the valuation gap between the two companies has forced the management to delay their plans. Currently, any A&P spent by APL is disproportionately benefiting Tricoat.

Catalyst

demand recovery post covid slowdown; industry consolidation with smaller players finding it difficult to survive; the success of new products; and company successfully demonstrating margin improvement.